The recent stock market rally is eerily echoing the performances of the past. The fact that the market has increased more than three folds in less than 3 years is something to be marvelled at. The reasons behind the increase can long be debated and talked about. Whether it was the falling interest rates, the stable currency or the fact that the market had stayed undervalued for so long. The final conclusion could be that it was a mix of all these factors coming together.
The catch is that this is not the first time such a rally has been seen.
While the market reaches new highs, there is a sense of certainty and security that is seen in the market. The older players of the market feel that the crisis and market crashes of yesteryear have helped the system build guard rails for itself. With the help of National Clearing Company of Pakistan and Securities and Exchange Commission of Pakistan, there were many steps taken to protect from future catastrophes. One such measure was the establishment of the Margin Trading System (MTS).
In the wake of the 2005 stock market crisis, in house badla was seen as the major culprit for the crash taking place. So what exactly was in house badla and how did it wreak havoc? And more importantly, what was done to protect the market?
What happened in 2005?
To get a sense of what was going on in the market in 2005, we have to take a long walk down memory lane. After the US initiated its war on terror in 2001, there were many positive developments in Pakistan’s stock market. Economic indicators were on the up and up and the results were being seen on the Karachi stock exchange which was the primary stock market in the country.
Foreign exchange reserves were increasing, interest rates were low, the banking sector was expanding rapidly, remittances were on the rise and the government was looking to privatize many of its state owned enterprises. Based on these developments, the investor sentiment was strong and optimistic and the stock market was the most attractive avenue for investment.
The bull run started in 2002 when the market rose from 1,500 points in 2002 to 10,300 points by March of 2005. This was an increase of almost seven folds. Comparing the market rise of today seems miniscule in comparison. In addition to the index increasing, the daily volumes were also touching all time highs. With the prices and volumes increasing, the market capitalization of many of the companies increased manifolds. The media was touting the market as the best performing stock exchange in Asia based on the increase.
As the index was increasing and returns were multiplying, the market was ripe for speculators to enter. With no end in sight of the bull run, there was an expectation that the music would never stop and the party could go on forever. This feedback loop was further reinforced by the fact that there was easy credit available for the speculators. This proved to be an upward spiral as speculation would fuel the market run which would further increase the speculation in the market as well.
The source of this easy credit was called in-house badla. This allowed investors to buy large amounts of shares based on borrowing at cheap rates from lenders. In-house badla was a market in which lenders were willing to lend funds to borrowers who could leverage their position by buying a large quantity of shares while investing a portion of this investment. The wisdom behind this buying was that, as the market would keep increasing, any profit earned by the trade would be more than enough to cover the cost of borrowing.
Another aspect which was fueled by this kind of borrowing was that lenders could move funds towards shares that they wanted to manipulate. For example, a lender would allow a borrower to borrow at a lower rate if the buying was going to be carried out in a stock of their interest. This allowed them to influence the price in their favour.
The biggest problem of this lending system was that it was informal and was maintained off the books. In many cases, the regulators and even the market participants had little to no knowledge in regards to the size of the leverage market. What this meant was that people would see the performance of the stock exchange and marvel at the increase rather than knowing that the exchange was becoming more and more fragile by the day.
With the system being supercharged by speculators and higher market prices, the fundamentals of the market started to lag behind the valuations and a bubble was being created. With little in the way of oversight and regulation, the badla market kept growing in size with the influence of the market being monopolized by a chosen few. The reality was going to hit the market and hit it hard.
With market prices and badla volumes becoming unsustainable, the share prices started to fall and led to a cascading effect. The thing with leverage is that it works very well when the asset prices are increasing. The profits are being earned and they are more than enough to cover the costs. Even the collateral being used to take on a bigger position is also increasing in value in conjunction with the share price. The downside of leverage hits when the share prices start to fall.
And that is what happened in March of 2005 when the KSE-100 index crashed from 10,300 to below 7,700 points. When share prices start to fall in a leveraged market, the issues start to grow exponentially. The fall in price has to be covered by the investor while they still have to pay the cost of borrowing. As the collateral losses value, they have to put up more assets to cover their borrowing. As the losses start to accumulate, liquidation of the position has to be carried out at discounted rates which further depletes the value of the share and its collateral.
The upward spiral is followed by a more vicious and dangerous downward cycle as shares keep plummeting and there is no stop to where they will go. Soon the contagion starts to hit the lenders who had lent the funds in the first place as the lack of liquidity threatens their survival. With the lenders failing to make their payments, the domino effect takes the whole system down with itself as the default bleeds from one lender to the next.
Enter the devil
So how did in-house badla make things worse? As already stated, the fall in the market would be problematic in any situation. The problem that was posed by the badla market was that it was unofficial and off the books so there was no record as to how large the market had become. As there was no official way of documenting these transactions, the lenders could set the terms and change the terms as they wished.
As the market started to fall, the lenders started to fear for the money they had lent and started to call these loans back. This created a panic in the market as borrowers could do little. They could not sell their holdings to free up the funds as the market was falling. This led to the market free falling. As lenders had kept some security and collateral against the borrowings, they started to sell these pledged shares as well in order to recover any value they could. All these factors combined to accelerate the crash further and further.
In the aftermath of the crisis, it was seen that many of the lenders or brokers ended up defaulting on their commitments. Others were able to use the rally to make large gains driving up prices and then exiting the market leaving the smaller investors to suffer huge losses.
SECP set up an inquiry commission under Justice Saleem Akhtar who submitted a report on the causes of the crisis. The commission stated that the in-house badla was the main reason as it turned the exchange into a casino which was run by the powerful brokers. And just like a casino, the brokerage houses always won. It also alleged that there was a conflict of interest between the brokers and the board of directors of the Karachi Stock Exchange as they controlled many of the seats of the directors as well.
Establishment of MTS
One of the solutions that was put forward by the commission was to establish a Margin Trading System (MTS) in place of the in-house badla. It is impossible for the stock market to function without leverage. In certain products like future markets, leverage is actually baked into the product. In face of this, it was felt that rather than having an informal system off the books, there was a need to have a more formalized manner to allow for leverage based trading to be carried out.
Leverage is helpful as it enhances market depth, liquidity and allows for greater investor participation to be carried out. Margin Trading allows an investor to buy securities by paying for a portion of his total investment and borrowing the rest from a financier. This financier can be a bank, a brokerage house or even a mutual fund which is allowed to lend to investors. The investor is able to enjoy a greater purchasing power leading to an increase in the activity in the market. The downside, however, is that there is added risk as the exposure of the investor is greater to any fall in the price.
The mechanics of the system are quite simple. An investor buys a security that is declared eligible by the NCCPL under the eligibility criteria that is set by them. This makes sure that investment is not being carried out in a stock which has weak fundamentals. The investor only has to put up the funds for 15% of the value of his purchase which means that they can multiply their holding by almost 6 times their investment. The remainder is provided by the financier or the lender in this case. The upside for the lender is that they get to earn a mark up for the lending carried out.
In order to make sure that proper accounting of all the transactions is maintained, the NCCPL has developed a system through which the transactions are executed on a daily basis. Just like regular trading terminals, a terminal can be accessed by borrowers and lenders who are willing to borrow or lend respectively.
In order to make this system secure, only certain eligible securities are allowed to be traded on the system to make sure that the securities are of the highest quality and have a strong track record behind them. To control the size of the market, a cap of 20% of free float is kept which means that no more than 20% of the free float of a share can be traded cumulatively.
In order to protect the lenders and borrowers from any credit risk, cash margin requirements are maintained and adhered to by NCCPL which makes sure that any sudden rise or fall in the market price of the share is protected and these margins are adjusted accordingly to make sure there is ample collateral against the borrowing carried out. In case a share price falls, the borrower has to bring back the margins back to the required levels on a daily basis.
To not let the funding dry up, the lenders are mandated to provide the funds for a period of 60 days or two months. At an interval of every 15 days, 25% of his lending is released which means they can get back their lent funds in a timely manner. They can choose to lend these funds again if they choose so. The borrower is also protected as they have a period of 60 days before all of their funds are taken away from one lender. This allows them the flexibility and ability to use the funds for at least 15 days and then choose to borrow from a new lender if they are being given better terms.
In terms of regulations, the SECP has also enacted rules such as the Securities (Leveraged Markets and Pledging) Rules, 2011 which cover margin trading systems and other aspects of securities lending and borrowing.
Same same but different
The fruits of the new measures can already be seen now. Just like in 2001, interest rates are declining, foreign reserves are stable, remittances are on the rise and there is another privatization drive being carried out. Just like the run up to 2005 crisis, the index has been increasing steadily on a monthly basis with no end in sight. However, the biggest difference is that there is no chance of a shock that can be carried out ala 2005.
The MTS system has been deployed in order to make sure the withdrawal of funds by one financier cannot jeopardize the whole leverage market system. The mechanisms that have been built make sure that there is ample liquidity in the system which cannot dry up in a matter of days. This sense of security makes sure that all market participants are sure that they will have easy access to funds on a consistent basis and there is trust that has been integrated.
The recent market rally seems to be going past new historical thresholds on a daily basis and there are expectations that the index could reach 200,000 points in the next few months. The stock market crashes of 2000, 2005 and 2008 have scared older investors who are skeptical of the way the index is increasing on a daily basis. Their skepticism is justified to the extent that the carnage they saw with their own eyes is difficult to forget. For them to fathom such an increase on the back of little change in the fundamentals of the economy can be rationalized to some extent. What they fail to realize, however, is that the guard rails that have been placed are designed to withstand the rigours of the new normal.
